Banco Sabadell : BUY Tier 2 and AT1; Potential market volatility subsequent to the Catalan elections could offer investment opportunities

Banco Sabadell has strengthened its credit fundamentals in 2017, described as a transition year by management, notably by using the proceeds of asset disposal proceeds to increase non-performing assets (NPA) coverage. After the success of its 2014-16 plan, whose objectives were broadly attained, the group is ready to successfully execute a reasonably ambitious and well1earticulated 2020 plan. Idiosyncratic risk on the credit therefore seems contained. - Political risk spiked following the result of the Catalan referendum in October and hit the bank, which has strong positions in the region and was registered in Catalonia. Banco Sabadell was quick to transfer its head office outside the region to lift any uncertainty about its legal regime and supervision and to maintain access to ECB funding. Deposit withdrawals were relatively short-lived and of limited volume, and clients returned to the bank after it transferred its headquarters. A few days ahead of elections, opinion polls put separatist and unionist parties neck-and-neck, and a resurgence of market volatility is possible in the short term following the outcome of the elections. However, our economists' baseline scenario is that Catalonia will remain within Spain. This would be beneficial to the performance of its regional and national economies, and hence to that of domestic banks. - We maintain our NEUTRAL recommendation on Banco Sabadell’s senior debt securities showing fair returns; confident in the bank's fundamentals and in the evolution of political risk in Spain, we recommend investors to BUY the Tier 2 (Ba3/BB) and the AT1 (B2/B+) securities of Banco Sabadell which offer attractive returns, both in absolute terms and among their respective asset classes. The potential period of market volatility post-elections could create entry points for these securities. - >Support factors - - Solid franchise in Spain, notably in the SME segment, supplemented by a challenger position in the UK with TSB.- Proven capacity to execute an ambitious growth strategy and to successfully integrate the acquired banks.- Continued improvement in asset quality (NPL ratio of 5.4%) and efforts made to increase NPA coverage with impairment reserves.- Our economists' baseline scenario: Catalonia remains within Spain. Points to watch - - Political risk and induced volatility in the short term, although this creates investment opportunities, as we noted above. - Fairly significant negative impact (potentially above 50-60bp) of the implementation of IFRS9 on the CET1 ratio (13.2% phased-in at 30 September).- A relatively high volume of debt to be issued to meet expected MREL requirements.